Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

I did not realize this topic has caught so many readers’ attention over the past few weeks, and I feel there is a need for me to continue this topic for at least one more week so that my readers will not be misled by what I have been trying to say in my last two related articles. I also wish to thank Eloy Fenocchi, one of our fellow instructors, for inspiring me to write this article.

Let me put the statement I wanted to express in the proper context:“Under favorable circumstances, it is advantageous for a trader to sacrifice profitability for probability.”  The caveat thereof is that you should not follow this statement blindly without due regard to the proper risk management.

Let me explain with the aid of the following example as to why I prefer to be a probability trader, and consider probability in my options analysis:

At the time of writing this article, which was March 18, 2008, I pulled out the following option chain for Spider (SPY) for the month of April 2008. SPY closed at $128.30 on March 17, 2008 and there are 32 days to April expiration.

Using our friend Bok as our example trader, let''s suppose his prognosis is that he is not bullish on the US market in the near future. One possible pick may be to sell an April 129-130 Call Spread for a credit of $0.50. Now, I am aware that this pick may be debatable and even the price sought to be filled may be aggressive. As SPY is a very liquid ETF, it is possible to get this filled at the mid-point based on my experience and with some help from the daily volatility.

Assuming that this Call Spread is filled, Bok will be risking $0.50 for $0.50 per contract—the reason being that the spread is worth $1 and Bok collected $0.50 upfront. So, the true risk of this spread is $0.50 per contract. Take a look of the options chain again. The Apr 129 Call has a 47.04% probability of expiring in-the-money [ITM] by April expiration, other things being equal. In other word, there is a 52.96% probability that this option can expire out-of the-money [OTM] by April expiration. In my humble opinion, I would say that from the risk/reward profile, taking into account the probability analysis, this trade is better than a coin-flip because Bok’s expected return is $0.03 [$0.5 x 0.5296 - $0.5 x 0.4704]. Having said this, I understand that each of us has different trading style and risk assessment. To me, my personal trading style is quite close to Bok’s in this illustration, and I am absolutely fine to go for such a “better than coin flip” trade, provided that my prognosis is in line with Bok’s.

All right! Perhaps you may not feel comfortable with such a “better than a coin flip” trade and want some more safety by going further OTM. There is nothing right or wrong about having this mindset, as this is a reflection of individual’s risk assessment and tolerance. So, let’s say another trader, Alec, is more risk adverse, and decides to sell an April 131-132 Call Spread for a credit of $0.41. So, Alec is risking $0.59 per contract. From the option chain, you can see that there is a 39.31% probability that April 131 Call will expire ITM by April expiration or a 60.69% probability that it will expire OTM by April expiration, other things being equal. I am not suggesting that this trade is better than Bok’s “better than a coin flip” trade. However, you may notice that by giving up $0.09 per contract, the probability of success can be pushed up from 52.96% to 60.69%. So, this is what I meant by sacrificing profitability for probability.

Notwithstanding the above, as alluded to by Eloy in his feedback, I felt that it is important at this point to stress that no matter what, both Bok and Alec have to give due consideration on the risk analysis. Indeed, there is the saying – “high-risk trade gives you high probability of success, and low reward.”  It does not mean that a high probability trade is a sure win. It is because of this that one should not bet the whole farm by allocating a significant portion of his/her capital in a single trade. Eloy’s feedback came as a timely reminder. As professional traders, we must each ask ourselves, "What if I am wrong?" before placing the trade. What this means is that, for Bok and Alec, they have to ask themselves if they can afford the risk of being completely wrong.

Let me illustrate how important it is on risk allocation. Let’s assume that Bok and Alec decide to allocate $1,000 on this trade. Bok can sell a maximum 20 contracts, risking $1,000 for a credit of $1,000. If Bok is dead wrong, he will lose $1,000 on this trade (before commission). Based on my calculation, Alec can only sell 16 contracts, risking $944 for a credit of $656. If Alec is dead wrong, he will lose $944 on this trade (before commission). Whether both traders can keep their credits eventually is unknown as this point. But this business to me is not risky, if you know what you are doing, and know how to manage your risk. Surely you don’t want to bet more than what you can afford to lose in high probability trades.

To sum it up, while thinking about probability, keep in mind the importance of proper risk management. You would not like to be out of the game by betting the whole farm.


Jack Wong 
Staff Writer
Optionetics.com ~ Your Options Education Site

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jack Wong, Optionetics.com

• May 12, 2008
  Seven Essential Credentials of Successful Optionetics Students, Part VI
• May 5, 2008
  Seven Essential Credentials of Successful Optionetics Students, Part V
• April 28, 2008
  Seven Essential Credentials of Successful Optionetics Students, Part IV
• April 21, 2008
  Seven Essential Credentials of Successful Optionetics Students, Part III
• April 14, 2008
  Seven Essential Credentials of Successful Optionetics Students, Part II